Tout va bien ?

1 novembre 2019

Chris Iggo , CIO Core Investments

The end-cycle slowdown could still end up in a recession in the next year or so. But it would be an odd one. Real rates never got anywhere near as high as before previous recessions in the US and the Fed has taken steps to reverse a good part of the tightening it put in place in 2016-2018. Yet there is pessimism because of the ongoing tensions that continue to threaten the global hegemony. Markets don’t trade like a recession is coming. The October US payroll number, showing job gains of 128,000 and an unemployment rate unchanged at 3.6%, doesn’t suggest it either. Risk has done well this year. There are downside threats to growth, but the “blah” trade is that nothing that much changes. That should mean be fully invested.

Gentle slope...

The summary of the IMF’s October World Economic Outlook stated that the “outlook (for the global economy) remains precarious”. By all accounts, the mood in Washington at the joint IMF and World Bank meetings was relatively downbeat with policy makers, bankers and investors focussed on the ongoing uncertainties around global trade and the weakness seen in manufacturing data. Economic forecasts have been revised down accordingly compared to earlier this year. These concerns about the outlook are not new and were discussed at length in the previous IMF outlook issued in April. However, since then monetary conditions have been eased in the US and Europe. This is a key reason why financial markets have so far avoided “recession-like” negative returns and why markets have been much stronger than what might be implied by the consensus economic prognosis. Investors are not blind to the macro-cyclical risks. However, they have been focussed on the probability that the current trade tensions between the US and China can be eased by an agreement not to raise any more barriers and that a deal could be done that eventually sees the UK exit the European Union. Our view is that these expectations are likely to be met, at least in part. Easier monetary policy is also a cause to be more optimistic. To that extent, market returns are consistent with some cyclical improvement in the quarters ahead. Perhaps markets have been right not to price in a more pronounced downturn. Despite some volatility in recent weeks, growth has outperformed value in the US equity market over recent quarters and credit has outperformed rates in global fixed income. However, there remains a darker scenario for the global outlook that does see a further deterioration international economic and political collaboration, a more pronounced economic downturn and the flaring up of populist unrest the likes recently seen in Chile and Iraq. This may not be the mostly likely outcome, but investors need to be aware that markets are not priced for this “risk” scenario with the S&P500 price index at an all-time high.

…or steep drop?

The IMF does forecast a slight pick-up in global growth next year. However, this is conditional on “defusing trade tensions, reinvigorating multilateral cooperation, and providing timely support to economic activity where needed”. These are big asks. Timely support to economic activity is likely to mean transparent fiscal policy initiatives in a number of developed economies. To sustain a positive view on market returns investors need to see progress on trade (i.e. no further protectionist moves) and on Brexit. Some visibility of a stabilisation of the cycle is also required, coming from purchasing manager surveys and evidence that the weakness in the industrial cycle over the last year has not spread to labour markets and consumer confidence. My concern is that there is plenty of potential room for disappointment. The risk scenario would take the form of a further deterioration in international economic and political collaboration, a broader economic slowdown and further flare-ups of populist unrest the likes of which have been seen in recent months in Hong Kong, Chile and Iraq. It would not be a surprise if, from time to time, market volatility spikes higher as these concerns come to the fore.

Polling and…

The political cycle is very important in determining investor sentiment. We are close to being a year away from the US general election. According to Gallup, the current job approval rating for Donald Trump is 39%, which is close to the average so far for his term in office (40%) and is slightly below that recorded in the October of the term of President Obama, and significantly below scores recorded at the same time of the terms of all previous Presidents going back to Jimmy Carter in 1979. Trump faces a hostile House of Representatives seemingly intent on pursuing “impeachment” and thus needs the economy to remain strong. So, the bull case is that he does a deal with China which allows some revival of business and investor confidence. Together with the easier stance from the Fed, the economy does well into 2020. I was in New York and Los Angeles over the last two weeks. These are not representative of the whole of the US, but I would say things are going pretty well based on those two urban juggernauts. However, what needs to be watched is Trump’s campaigning focus. There is an argument that his style is to create tensions and then claim credit for defusing them. In that case a deal with China might just be backing away from any further trade protectionism while retaining the option to “go after” China again if he is re-elected. Moreover, he may turn his attention to Europe. What is not clear at this stage is whether popular support for his “America first” approach will be greater than support he would get if the economy was able to benefit from a more collaborative international stance.

…voting

The situation with Brexit is similar. Boris Johnson struck a deal with the EU but has not been able to get it ratified by the UK parliament. So, a general election will be held instead. If the Conservatives win then the deal may then be ratified and that would remove some uncertainty in the short term, allowing economic sentiment to recover. On the other hand, a hung parliament, which is not unlikely, would delay Brexit further and raise the probability of “no-deal”, with clearly negative consequences. At the moment, the opinion polls are pointing to a Conservative majority, but the campaign is just beginning and, like it or lump it, the divisions over Brexit will be key to determining the outcome of the election. For both the US and the UK, elections over the next year will be a key test of just how far the “populist” revolution has gone. If they legitimise the more nativist political mantras of Trump and the “Brexiteers” then the outlook for a return to a more “liberal global order” will not be bright.

Populists = steeper curves, perhaps

opulism is somewhat at odds with the orthodoxy of inflation targeting and fiscal stability. Essentially populists want to buy votes. We’ve seen that with the fiscal stimulus in the US and with pressure from the President on the Federal reserve (Fed). The UK campaign will not be about austerity and the need to balance the books but will be about spending pledges. Although there are plenty of reasons why bond yields are going to remain low for the foreseeable future, ceteris paribus, populism would tend to more government borrowing, higher bond yields and higher inflation. As a result, I think inflation break-evens remain an attractive hedge for fixed income portfolios given just how low the market is pricing inflation over the medium term. Central bankers like to look at forward prices for inflation and these remain close to their lows – 1.2% for the Euro area and just under 2% for the US. If the inflation markets are right, we are condemned to another decade of very low interest rates and very limited returns from bonds.

Easing

As I mention above, the monetary environment has become easier. The Fed cut interest rates this week taking the Fed Funds rate down to a 1.5%-1.75% range, 0.75% from the peak reached last December. The message from the Fed was that it is likely to be on hold now with future data determining whether there will be more rate cuts. It’s hard to say with any real conviction whether there will be more cuts this cycle. Markets currently price a 27% probability of a December rate cut and there is only a 4% chance that the Fed Funds rate will be reduced by another 100bp over the next year. The Fed’s “dot plot” has a median forecast for more or less unchanged rates from here. The key is whether the Fed and investors think that the three cuts since June are enough to support the US economy in the face of the slowdown that is very evident in manufacturing (see the latest Chicago Purchasing Managers Index which came in at a 5-year low of 43.2 in October). While the Fed would like to see inflation higher, it is today high enough to mean that the “real” Fed Funds rate is back below zero. History tells us negative real policy rates are seen after a recession not before one. My guess is that the outlook is skewed enough to the downside to make the next move in the Fed Funds another cut but not necessarily in December.

Where were you in the great 2019 rally?

October was definitely a risk-on month. Japanese and emerging market equities were the best performing markets while long duration provided a negative return for the second consecutive month. Once there appeared to be some better news on the trade front, growth started to outperform value again in equity space, consistent with the rally in the overall market towards month-end. One thing that has struck me in conversations with clients and market participants is that the performance of risk in 2019 has been a surprise and has not been fully participated in. Now, as year-end approaches and with plenty of issues unresolved, investors are still reluctant to be overly positive on markets. Rates are still suggesting downside risks. Some of the economic data is weaker. Politics could turn ugly. Most importantly, valuations are high for almost everything. European high yield is 3.4%. Emerging market debt yields 5.1% but the investment grade part of that universe only 3.55%. The dividend yield on the MSCI World index is 2.5%. These are not yield levels that are going to encourage investors to easily part with their cash. It also makes it difficult to start setting an investment strategy for 2020. Should we expect a repeat of this year? That will be hard in the bond space because we’ve already had a lot of easing by the Fed and the 10-year Treasury is likely to start 2020 at least 100bp lower than where it ended 2018. The move alone was worth around 5.75% of total return on the US Treasury index. To get the same in the next twelve months would require Treasury yields to fall well below 1% (to new all-time lows). That would only happen in an adverse economic situation with the Fed easing more aggressively. In that scenario, equities would be unlikely, in my view, to match the +20% returns seen this year.

Towards 2020

Asset allocation will be challenging. The value of fixed income when yields are this low is almost all about capital preservation and using duration as a hedge for credit and equity positions. Losing money in long bonds might be a price worth paying in a risk-on environment when and if equity returns are strong. Positioning for different events will also be tricky. There is the US election which might boil down to a choice between four more years of Trump or a business-unfriendly candidate from the Democrats. Either could be challenging for US equities, with Trump possibly threatening to continue pursuing aggressive trade policies and someone like Warren threatening disruptive policies in number of industries, like healthcare. But one trade might be worth considering and that is the post-UK/Brexit done scenario. While there is some time to go and there are many moving parts to this coming election, a Conservative majority being able to pass the Withdrawal Bill will be bullish for the UK. Sterling could rally further on such an outcome and UK equities, which have underperformed all year, might receive some much-needed allocations.

Champions?

Could England be on the verge of a second major sporting World Cup triumph in one year? The Rugby World Cup final will see a lot of people put off their usual Saturday morning chores tomorrow to see if England Rugby can repeat the heroics of their cricket counterparts earlier this year. While I am just too young (don’t say that much these days) to remember the 1996 football triumph, I clearly remember Johnny Wilkinson kicking us to victory in 2003 and Ben Stokes heroics in July are still fresh in my mind. So, another World Cup would be great. My particular locality in South West London has more than its fair share of South African residents, so it could be a lively morning in Clapham and Wandsworth. I’m sure it will be a great occasion and it will cap what has been a fantastic tournament, thanks to Japan. Another on-the-road win for Ole’s rejuvenated team would also be welcome on Sunday. I can’t quite believe United are suddenly 7th in the Premier League after recently flirting with the relegation zone. Not to say everything is rosy again but the kids are finding their feet. And if Rashford can pull those Ronaldo-esque free-kicks out the bag, things should be fine.

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